John Harrison: The future could be superfunds

Having started a process of consultation about changes in the structure of the LGPS in 2013, it is disappointing that the sector has begun 2015 still waiting to hear if the government has a blueprint for the future. But what should a sensible future structure look like?

The biggest challenge facing the LGPS is affordability. The cost of providing pensions for past and future service has been challenged by a horrible combination of increasing life expectancy, falling long-term gilt yields and volatile asset markets. The end result has been uncomfortably large deficits for many authorities and huge pressure for contribution rates to rise.

Ultimately there are only three possible ways to improve affordability. Two are seen by most as unpalatable – reducing pension benefits to members or increasing employer contributions even faster. Not surprisingly the focus has been on the third – generating net of fees investment returns far higher than the growth in liabilities.

To a large extent achieving such an outcome is not within our control because it depends on the vagaries of financial markets. Growth assets, such as equities, have to perform better than liability drivers, such as index-linked gilts. However, it is possible to improve our chances, either by becoming cleverer at investment or by reducing the associated costs.

The government’s consultation exercise has been heavily skewed towards reducing costs. Initially enforced fund mergers were seen as possible way to achieve this, but the latest proposals instead seemed to favour enforced moves into passive mandates and outlawing fund-of-fund structures.

The central problem with this solution is that it seeks to reduce costs by becoming less clever at investment. The sector needs to do more to mitigate liability risks and to find a broader range of growth assets so that it is less of a hostage to equity market swings. Passively following a market capitalisation-based equity or bond index does not achieve this. Driving funds to reduce costs will not improve diversification. It will deliver a cheaper rollercoaster ride, not a smoother journey to full funding.

There is an alternative approach evolving that may achieve lower costs and better investment outcomes. This is for schemes to collaborate on a voluntary basis both to increase their buying power and to improve their investment skills.

Voluntary collaboration is not a new concept in the LGPS. Northamptonshire and Cambridgeshire created LGSS in 2010 to drive administration savings. Multi-authority framework agreements were first established by Croydon in 2011 and have evolved into the National Framework more recently. Bilateral and trilateral arrangements have also been proposed, although they have sometimes stumbled over issues of implementation.

Perhaps the most ambitious in terms of the number of authorities involved is the London Collective Investment Vehicle (CIV). While the scale of the ambition is to be admired, the sheer number of authorities involved may make the implementation of the new CIV structure problematic.

In my view the collaboration that seems most likely to set a new template for the LGPS is the creation of Asset Liability Management (ALM) by LPFA and Lancashire announced in December 2014. These are two large but similarly sized LGPS schemes with established in-house investment capabilities. They have similar investment beliefs. And they are not neighbours, which perhaps helps. It has been reported that other LGPS funds have expressed interest in joining ALM. In due course ALM may become a superfund of £30bn or more.

If it is able to navigate the complexities of establishing a combined investment operation, ALM may in time provide the LGPS with a new yardstick for investment effectiveness. It will start with the internal resources, expertise and governance to handle greater complexity in liability and investment management, while its growing scale will give it the leverage to drive lower fees from investment managers.

If ALM delivers on investment return and cost, the future of the LGPS may become that of several voluntary superfunds. If it fails, the current structure of autonomous authorities will probably remain. In three years we will know. And perhaps we will have heard the outcome of the consultation exercise by then as well.

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